Used-car dealer CarMax (click ticker for report: ) reported stellar third-quarter results Thursday morning. Revenue surged 15% year-over-year to a better-than-anticipated $2.6 billion. Earnings also grew 15% year-over-year to $0.41 per share, easily exceeding the consensus estimate. Our fair value estimate is unchanged.
Given how the new-car recovery continues, it may seem surprising that CarMax would see such strong sales gains. Used-car revenues jumped 17% year to $2.06 billion, with total units jumping 16% and comparable store units jumping 12% compared to the same period last year. However, this shouldn’t be too surprising, in our view, given the aging fleet of cars in the US coupled with the better used-car inventory stimulated by the new car recovery. As consumers purchase new cars from Ford (click ticker for report: ), GM (click ticker for report: ), Honda (click ticker for report: ), and Toyota (click ticker for report: ), these buyers put their previous vehicles into the used car market (generating better offerings).
For the past several years, this market’s growth has been constrained by tight supply and a general lack of newer used vehicles. Therefore, growth in new car sales should result in a growth in desirable used cars. Since 2007, car sales have been incredibly weak and mostly below replacement rate; thus pricing should hold up relatively well, too.
Though sales jumped significantly, gross margins slipped 10 basis points, to 13.3%. However, CarMax mostly controlled selling costs, which jumped 14% on an absolute basis due to variable sales compensation (commission), but fell 10 basis points to 9.9% of sales. Unfortunately for the firm, one of the negative effects of having better product selection is higher costs and therefore lower margins. Used-car profit per unit fell 1% year-over-year to $2,146—a number that we think has additional downside.
While CarMax does very little in terms of new car sales, it is interesting to note that the figure fell 0.7% compared to the same period last year to $45.7 million. We do not think this is materially representative of the new car market, but profit per unit halved to just $518. Even wholesale units earned higher profit per unit ($923), suggesting the new car market has become more competitive and incentive-laden. Or it could be an aberration—it is difficult to tell with such a small sample size.
A significant portion of CarMax’s sales growth can be attributed to looser credit standards:
“CarMax Auto Finance. CAF income increased 16% to $72.5 million compared with $62.6 million in last year[‘]s third quarter. The growth in CAF income was largely attributable to the 15% increase in average managed receivables, which grew to $5.48 billion from $4.77 billion in the prior year period. The increase in average managed receivables reflected the rise in CAF origination volume throughout fiscal 2012 and fiscal 2013 as we transitioned back to our pre-recession origination strategy, higher average amounts financed and the growth in retail unit sales.”
We’ve previously noted that subprime lending to auto purchasers is less risky than subprime mortgage lending, though it certainly raises the company’s receivables risk profile.
Overall, we were impressed by CarMax’s strong results. Though the allowance for doubtful accounts receivable increased to 1% (was 0.9%), we think the company’s decision to allow easier credit has propelled revenue in a favorable direction. We believe financing income will grow, and we think buyers should be able to make payments (assuming economic conditions do not substantially deteriorate). Management continues to open new stores (8 out of 10 stores expected to be open in fiscal year 2013 already are), with plans to open an additional 10 superstores in fiscal year 2014. Nevertheless, we believe shares are fairly valued at current levels, and we’d rather play the auto recovery via Ford, which is a member of the portfolio of our Best Ideas Newsletter. Superior (click ticker for report: ) is a holding in our Dividend Growth portfolio.